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02 News Update Summer 2007

f e a t ur e ar t i c l e

Introduction

In 2005, the House o Lords in National Westminster Bank Plc v.

Spectrum Plus Limited & Others [2005] 4 ALL ER 209 unanimously

overruled the long standing authority laid down more than 25 years

ago in Siebe Gorman v. Barclays Bank Ltd . [1979] 2 Lloyd’s Law

Reports 142. In the Siebe Gorman case, Slade J held that a charge

over past and uture book debt was a xed charge i it prevented

the chargor rom disposing o the uncollected book debts and the

chargee allowed the chargor to deal with its debtors and collect

the debts. Debt proceeds had to be paid into a designated account

with the chargee bank, but the chargor was allowed to draw on the

accounts reely or its business purposes.

Beore the House o Lords, National Westminster Bank Plc

(‘Natwest’) asserted that the charge over book debts was xed and

demanded payment o the book debt proceeds rom the liquidators

o Spectrum Plus Limited (‘Spectrum Plus’). However, the Customs

and Excise Commissioners, the Commissioners o Inland Revenue

and the Secretary o State or Trade and Industry (‘Crown

Creditors’) together resisted Natwest’s claim that the charge was

xed and argued that the charge was foating so that they were

entitled to the proceeds in priority to the bank. The House o Lords

reversed the Court o Appeal’s decision which gave judgment in

avour o Natwest and that the charge granted to Spectrum Plus

was xed. Their lordships unanimously upheld the decision o the

rst instance court which held that Natwest’s charge only created

a foating charge over book debts and that the Crown Creditors

had priority to be paid beore Natwest and that Siebe Gorman was

wrongly decided.

This article examines the decision o the House o Lords and

considers some o its implications on the banking sector.

Facts o the Case

Spectrum Plus obtained an overdrat acility o £250,000

rom Natwest or the purpose o providing working capital to

the company. The overdrat acility was secured by a debenture

to the bank, which included a xed charge over all present and

uture book debts. The debenture was a Natwest standard orm

which was drated substantially the same as in Siebe Gorman. The

debenture prevented Spectrum Plus, without prior written consent

rom the bank, rom selling, actoring, discounting or otherwise

charging or assigning uncollected book debts. The debenture

did not prevent Spectrum Plus rom dealing with its debtors

and collecting its debts. Proceeds, once collected, Spectrum

Plus was required to pay them into a designated account with

Natwest to reduce the overdrat. Provided the overdrat limit

was not exceeded, Spectrum Plus was allowed to draw reely on

the account or its business purposes. The charge also required

Spectrum Plus, i so requested by Natwest, to execute a legal

assignment o the book debts in avour o the bank.

Spectrum Plus later went into creditors’ voluntary liquidation.

The liquidator collected the proceeds o the book debts in the

account but reused to account or them to Natwest. The bank

applied or a declaration that the debenture had created a xed

charge over Spectrum Plus’s book debts and that the liquidator

should hand over the proceeds. Under s.175(2)(b) o the Insolvency

Act 1986, (Hong Kong’s equivalent is s.265(3B) Companies

Ordinance) preerential creditors are entitled to be paid out o the

proceeds o a foating charge realization in priority to the foating

chargeholder. On the other hand, the Crown creditors joined in as

respondents and argued that the charge created was a foating

charge and Siebe Gorman was wrongly decided and that they were

entitled to the book debt proceeds in priority to Natwest.

Fixed or Floating Charge? House o LordsDecision in National Westminster Bank Plcv. Spectrum Plus Limited & Others(relevant to Paper 2.2 / F4)By Susan Leung

Lecturer, School o Accounting & Finance

Hong Kong Polytechnic University




Summer 2007 News Update 03

High Court Decision –

Natwest’s Debenture was a Floating Charge

In the High Court, Sir Andrew Morrit VC was o the view that

since Spectrum Plus had the reedom to deal with and use the

proceeds o the book debts in the ordinary course o business

through collection and ordinary operation o the bank account, the

book debts were under the control o the company. A restriction

which allowed collection and ree use o the proceeds was

inconsistent with the xed nature o a charge. Spectrum Plus’

s account with Natwest was an ordinary current account with no

restriction on its use or all purposes o the company’s business

so long as the overdrat limit was not exceeded. Whether a charge

was xed or foating, it did not depend on the intention o the

parties. I their intention, properly construed rom the language o

the instrument, was to grant Spectrum Plus rights in respect o the

charged assets which were inconsistent with the nature o a xed

charge, the charge could not be a xed charge despite the label

the parties put on it. Consequently, the charge over book debts

granted by Spectrum Plus to Natwest could only have been a

foating charge. Sir Andrew Morrit VC held that Siebe Gorman was

wrongly decided.

Court o Appeal Decision –

Natwest’s Debenture was a Fixed Charge

Natwest appealed. Lord Phillips MR delivered judgment o theCourt o Appeal and overturned the decision o the High Court.

He considered the construction given to the debenture in Siebe

Gorman correct and that the debenture required the proceeds o

book debts to be paid into an account o the chargee bank was

o critical importance in Siebe Gorman and could properly all into

the denition o a xed charge. Lord Philips thereore held that

a debenture imposing restrictions on the use o the proceeds o

book debts created a xed charge over book debts. Lastly, even

i the construction o Slade J had been wrong in Siebe Gorman, by

customary usage or more than 25 years, he would have held that

the orm o debenture acquired its meaning and eect as a xed

charge. The appeal would, accordingly, be allowed.

House o Lords Decision –

Natwest’s Debenture was a Floating Charge

The Crown creditors appealed. The House o Lords

unanimously reversed the decision o the Court o Appeal and

upheld the decision o the High Court to decide in avour o the

Crown Creditors. The Law Lords held that the critical question was

whether the restriction imposed on the account went ar enough o

the charge to be xed. In this case, Spectrum Plus was required to

pay the book debt proceeds into its current account with Natwest.

So ar as the overdrat limit was not exceeded, Spectrum Plus was

ree to operate on the account or its business purposes. The

Law Lords distinguished the present case with Re Keenan Bros

Ltd . [1985] I. R. 401 where the Irish Supreme Court held that

the charge on the book debts was xed as their proceeds were

to be segregated in a block account where they would be rozen

and unusable by the company without the bank’s written consent.

Thus, one o the ways to ensure a charge over book debts is xed

is to prevent all dealings with the debts other than their collection,

and to require the collected proceeds to be paid into an account

with the chargee bank. That account must then be blocked so as

to preserve the proceeds or the benet o the chargee bank’ssecurity. Accordingly, a debenture that provides or a truly blocked

account will be eective to create a xed charge.

However, in this case, although Natwest could, by notice,

withdraw or reduce the overdrat acility and amounts outstanding

on the account were repayable on demand, the account was in all

respects a current account with an overdrat limit. Pending such

a notice, Spectrum Plus was ree to draw on the account. Its





Fixed or Floating Charge? House o Lords Decision in

National Westminster Bank Plc v. Spectrum Plus

Limited & Others (relevant to Paper 2.2 / F4)

right to do so was thereore inconsistent with the charge being

a xed charge and the label placed on it could not make it xed.

The House o Lords thereore ruled that the debenture, although

expressed to grant the bank a xed charge over Spectrum Plus’s

book debts, in law granted only a foating charge.

Overruling Siebe Gorman

Lord Phillips MR in the Court o Appeal said that, even i Slade

J’s construction o the debenture in Siebe Gorman had been

erroneous, he would have been inclined to hold that the orm o the

debenture had, by custom and usage, acquired that meaning and

eect. This was because this orm o debenture had been used

or 25 years on the understanding that this was its meaning and

eect. Banks had relied upon this understanding, and individuals

had guaranteed the liabilities o companies to banks on theunderstanding that the banks would be entitled to look rst to their

charges on book debts unaected by the claims o preerential

creditors.

The House o Lords did not agree with this view. In their

opinion, banks and nancial institutions are sophisticated operators

and they should not have regarded the Siebe Gorman case as

having nally settled the law in this area. They were well aware o

the controversy surrounding the case and since Siebe Gorman was

only a rst instance decision, it was always liable to be overruled.

This view was put orward orceully by Lord Hope in his judgment:

“These are powerul considerations, but I am in no doubt

that the proper course is or the Siebe Gorman decision to

be overruled. … But the act is that it was a decision that

was taken at rst instance, and it has now been

conclusively demonstrated that the construction which

[Slade J] placed on the debenture was wrong. This is not

one o those cases where there are respectable arguments

either way. With regret, the conclusion has to be that it is

not possible to dene the decision on any rational basis.

It is not enough to say that it has stood or more than 25

years. The act is that, like any other rst instance decision,

it was always open to correction i the country’s highest

appellate court was persuaded that there was something

wrong with it.”

Retrospective or Prospective Overruling?

When overruling the Siebe Gorman decision, a more

controversial issue which had to be resolved by the House o Lords

was whether the overruling should take eect retrospectively

or prospectively. Natwest contended that i Siebe Gorman was

wrongly decided, the House o Lords should overrule that decisiononly or the uture. The bank submitted that the Siebe Gorman

decision should continue to apply to all transactions entered into

beore their Lordship’s decision in the present case, including

the debenture under consideration in this appeal. The bank’

s submission raised a controversial issue o major importance

concerning the power o the House o Lords to give a ruling in

prospective orm only. The bank argued that the House o Lords

had this power. The Crown Creditors were content to assume the

House may have this power.

Arguments put orward by the House o Lords against

prospective overruling in this case was that it was outside the

constitutional limits o the judicial unction o the courts. It would

amount to the judicial usurpation o the legislative unction o

Parliament. Also, it was said that power to make rulings having

only prospective eect was not inherent in the judicial rule o

the courts. A court decision which took the orm o a ‘pure’

prospective overruling did not decide the dispute between the





parties according to what the court declared was the present state

o the law. With a ruling o this character the court gave a binding

ruling on a point o law but then did not apply the law to the present

case as declared to the parties to the dispute beore the court.

Consequently, making such a ruling would not be a proper exercise

o judicial power. It gave a judge too much the appearance o a

legislator. Legislation is a matter or Parliament, not judges.

The House o Lords also highlighted the practical diculties

o applying prospective overruling as compared to retrospective

overruling. The advantages o retrospective overruling included

a court ruling on a point o law which applied in all cases past as

well as uture and the retrospective application o court rulings was

straightorward. On the other hand, prospective overruling created

problems o discrimination. In civil cases, ‘pure’ prospective

overruling could hinder the development o the law by discouraging

claimants rom challenging a prevailing view o the law. In ‘selective’

overruling, persons in like cases were treated dierently. For

example, the ability to obtain an eective remedy would have to

depend upon which o several challenges reached the House o

Lords rst. Consequently, this would introduce an arbitrary element

into the law.

Ater in-depth considerations, their lordships admitted that

there could be circumstances where prospective overruling would

be necessary to serve the underlying objective o the courts: to

administer justice airly and in accordance with the law. There couldbe cases where a decision on an issue o law, whether common

law or statute law, would have such gravely unair and disruptive

consequences or past transactions or happenings that the House

o Lords would be compelled to depart rom the normal principles

relating to the retrospective and prospective eect o court

decisions.

Taken altogether exceptionally, i the House o Lords, as the

country’s supreme court, were to ollow this course, it would not

be regarded as trespassing outside the unctions properly to be

discharged by the judiciary under constitution o the country. I

a legal system were to be operated in a rigid manner, it would

deprive its necessary elasticity. However, in the present case, it

was miles away rom the exceptional category in which prospective

ruling would be legitimate. No doubt over the years clearing

banks had to some extent relied upon the Siebe Gorman decision

when ormulating and using their standard orms o charges. But

banks who lent money on the security o charges on a company’

s undertaking were sophisticated operators. There was no reason

to suppose the Siebe Gorman decision had led them into a alse

sense o security. Besides, Siebe Gorman was a rst instance

decision and cannot have been regarded as denitively settling the

law in this eld. The House o Lords ruled that i the decision o the

present case were given prospective eect only, the result would

deprive preerential creditors o existing liquidations their rights and

priority given to them by statute. Consequently, the House o Lords

rejected Natwest’s submission that the decision should be given

prospective eect only.

Unresolved Problems

The decision o the House o Lords in this case has caused

controversies in the banking sector. Despite their lordships

agreeing that it was conceptually possible to create a xed charge

over book debts, they gave little practical guidance as to how aneective xed charge should be taken. The result o this is that it

will be dicult to know how a debenture will be interpreted by the

courts when it was being drated. In order or an eective xed

charge to be created, one view expressed by the House o Lords

was that the book debt proceeds had to be paid into a blocked

account controlled by the chargee bank and operated as such.

However, in practice this may not be a commercially viable solution

or the chargor as money may only be released rom the blocked





Fixed or Floating Charge? House o Lords Decision in

National Westminster Bank Plc v. Spectrum Plus

Limited & Others (relevant to Paper 2.2 / F4)

account with the specic consent o the chargee on a case-by-

case basis. The chargor may have to ace the urther uncertainty

that cash fow may be disrupted as the chargee has unettered

discretion as to whether to give or reuse consent.

Another problem resulting rom the decision o this case is

that many banks which have relied on the Siebe Gorman type

debentures will now nd that they have an inerior security than

they supposed to have. This will mean that they will have to adopt

a new strategy and to re-negotiate some o the terms o lending

acilities with their customers. Banks may require directors o these

companies to give personal guarantees in order to obtain loans or

their companies. This may prove costly to some small and medium

companies and deprive them o a valuable source o obtaining

business nance.

Conclusion

The Spectrum Plus case has no doubt claried one important

issue that in case o an ordinary secured nancing, a charge over

receivables will be a foating charge i the company is able to use

the proceeds in the ordinary course o its business. Thus, the

charge will not be xed i, in reality, the bank imposes only limited

control enabling the company to use the proceeds in its usual

course o business. However, one major uncertainty still remains:

the House o Lords did not deal with how much control by the

chargee is required in order to make the charge operate as a xed

charge. This issue may have to be dealt with by urther litigation

in the uture. Even i subsequent cases clariy the issue, banks will

always have an element o doubt as to whether a charge is xed or

foating.




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Objective o this paper

How interest income is taxable and how interest expense is

deductible are two popular questions raised in the proessional

examination and the daily work in the accounting and taxation

proessions. The deduction o interest may be ound under prots

tax, salaries tax and personal assessment. The objective o thearticle is not to cover all the three types o taxes, but restrict the

scope o this article to prots tax. The author will explain in this

article the dierent rules applied to the taxation and deduction o

interest and their relationship under prots tax. Ater reading this

article, students are able to grasp the essence o these areas o

knowledge and have a good result in the examination and a correct

tax treatment in their daily work.

Introduction

There are dierent types o interest income. These include:

a. interest income derived rom deposit,

b. interest income derived rom loan,

c. interest income derived rom clients’ trust money, and

d. interest income derived rom trade debts.

The same type o interest income received by dierent types

o businesses and entities may be dierently treated in the taxation

and deduction under prots tax.

Source Rule

Traditionally, the rule governing the taxation o interest income

is the “provision o credit test”. This means that the source

o interest income is derived at the place where the money is

rst made available to the borrower. Although this rule is still o

undamental importance in the taxation o interest income, yet

its signicance has been aded out gradually with the emergence

o new statutes and case law. This is particularly obvious in the

money lending business and banking industry ater the decision o

Orion Caribbean Ltd. v CIR (1997).

Interest Income Received on a Deposit

This may be, according to the nature o business carried on the

recipient, divided into two categories, namely: a nancial institution

and a company not carrying on the business o a nancial

institution.

a. Recipientisafnancialinstitution

The source o interest income received by a nancial institutionis governed by section 16(1)(i) o the Inland Revenue Ordinance

(IRO). The section provides that a nancial institution is taxable

on a global basis or the interest income which it receives. This

is an exception to the general Hong Kong taxation system which

taxes on Hong Kong source prot only. Thus, the interest income

received on a deposit by a nancial institution is always taxable

no matter whether the deposit is placed in Hong Kong or outside

Hong Kong.

b. Recipientisnotafnancialinstitution

Interest received on a deposit by a company not carrying

on the business o a nancial institution is governed by sections

15(1)() and (g) o IRO. The interest income received by those

entities remains to be taxable on a territorial basis. Only interest

income sourced in Hong Kong is taxable. Interest income derived

rom a deposit placed with a bank outside Hong Kong is exempt

rom Hong Kong prots tax.

Application o the “Exemption rom Profts Tax (Interest

Income) Order”

Beore 21 June 1998, Hong Kong source interest income was

chargeable with prots tax. The Exemption rom Prots Tax (Interes

Income) Order 1998was enacted and took eect on 22 June 1998

That order created a new category o interest income under prots

tax. It is the “exemption rom payment o prots tax”.

a. Exemptionromproftstax

I a deposit is placed with a bank outside Hong Kong, the

interest income derived thererom is sourced outside Hong Kong,

and it is exempt rom prots tax. I a deposit is placed in Hong

Kong, that interest income is chargeable with prots tax as it is an

onshore income.

Taxation o Interest, Deduction oInterest and their Relationship underProts Tax (relevant to Papers 2.3 HKG

& 3.2 HKG / F6 & P6)Patrick KW HO

Principal Lecturer

FTMS Training Systems (HK) Ltd.

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b. Exemptionrompaymentoproftstax

The Order 1998 exempts some Hong Kong source deposit

interest income rom payment o prots tax i certain conditions

are satised. I a deposit placed with a bank in Hong Kong is not

used as a security pledged against a loan, that interest income is

exempt rom payment o prots tax. The exemption rom paymento prots tax provided in the Order 1998 does not apply to interest

income received by a nancial institution.

c. Exemptionromproftstaxv.exemptionrompaymento

proftstax

Exemption rom payment o prots tax applies to oshore

interest income while exemption rom payment o prots tax

applies to Hong Kong source interest income.

The position o the charge o prots tax on interest income

derived rom a deposit may be summarised in the ollowing table:

(Note: F.I. means nancial institution.)

Interest Income Received on a Loan

This may be, according to the nature o business carried on the

recipient, divided into three categories as ollows:

a. a company not carrying on the business o a money lender nor

a nancial institution,

b. a company not a nancial institution but carrying on a business

o money lender, and

c. a nancial institution

a. Recipientnotamoneylendernorafnancialinstitution

The source o interest income derived rom a loan provided by

a company which is not a money lender nor a nancial institution

is governed by sections 15(1)() and (g). Only Hong Kong source

interest income is taxable. The chargeability is based on the

traditional source rule o “provision o credit test”.

b. Recipientbeingamoneylenderbutnotafnancial

institution

During the course o carrying on a money lending business,

the income is not derived rom the mere lending o money to a

customer. The income is also earned as an eort in evaluating the

risk o lending such as the repayment power and the creditability

o the borrower and the adequacy o security provided and etc. In

this situation, the source rule may rely on the operations test as

advocated in Orion Caribbean Limited v CIR, 4 HKTC 432.

In that case, although the lenders and borrowers were alloutside Hong Kong, and the provision o credit was also outside

Hong Kong, the judges did not rely on the provision o credit to

determine the source o interest income. The judges applied

operations test to decide the source o interest income. It was

ound that the source was in Hong Kong as the taxpayer’s holding

company arranged all the lending and borrowing activities on behal

o the taxpayer in Hong Kong.

c. Recipientbeingafnancialinstitution

The source o interest income derived by a nancial institution

is governed by section 15(1)(i) which provides that a nancial

institution is taxable on a global basis in respect o its interest

income.

As this appears to be harsh to the banking industry, the CIR

has made a gentleman agreement with the banking industry called

“compromised package” which is specically applicable to money

lending business carried out by a nancial institution. Under that

arrangement, the CIR does not insist to tax the interest income in

respect o a nancial institution on a worldwide basis.

Deposit Recipient not F.I. Recipient is a F.I.

Placed with a bank

in H.K.

As a security Taxable Taxable

Not as a security

Exempt rom

payment o prots

tax

Taxable

Placed with a bank

outside H.K.

As a securityExempt rom prots

taxTaxable

Not as a securityExempt rom prots

taxTaxable

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Taxation o Interest, Deduction o Interest and their

Relationship under Prots Tax

(relevant to Papers 2.3 HKG & 3.2 HKG / F6 & P6)



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The CIR looks at two actors in the determination o interest

income derived rom a loan. The two actors are:

a. the place where the loan is initiated, negotiated, nalised and

concluded, and

b. the place where the unds nancing the loan are raised.

I both actors are located in Hong Kong, all the interest income

rom that loan is taxable. I both actors are located outside Hong

Kong, all the interest income is exempt rom prots tax. I either

one actor is located in Hong Kong, only 50% o the prot is

taxable.

The situation may be summarized in the ollowing table:

Interest Income Received on Clients’ Trust Money

Many proessional rms, such as consultants, receive retainer

ee rom their clients or the provision o services at a later date.

These unds are kept in a separate trust account in the name o

the proessional rm as a trustee while the benecial owners o

such account are the clients. As a matter o practice, interest

is derived rom such trust account, and it is not oten that the

proessional rms will reund the interest to their clients in view o

small amount rom the angle o individual client. At certain intervals,

the proessional rms will transer the interest “unclaimed” by the

clients to the prot and loss account o the proessional rms.

Although the interest does not belong to the proessional rms,

yet it is credited to their prot and loss accounts. The issue is

whether such interest is taxable. Based on the decision o CIR v.

Lau, Wong & Chan, Solicitors, 2 HKTC 470 , such interest income

orms a part o the income o the proessional rm as a trade

practice, thus the interest income is chargeable with prots tax.

Interest Income Received on Trade Debts

According to paragraph 3 Inland Revenue DIPN 13, interest

has a Hong Kong source where it orms an integral part o a

trading transaction carried out in Hong Kong. In such situation,

the interest has the same source o the income as that o the

trading transactions. Thus, look at the case where the goods

are manuactured in Hong Kong, and the sales are made to an

overseas customer. As the source o the trading and manuacturing

prot is sourced in Hong Kong, the interest income derived rom

an extended credit period or the settlement o trade debt is also

sourced in Hong Kong.

Deduction o Interest Expenses and its Relationship with

Interest Income

Under the Inland Revenue Ordinance, income under prots

tax is assessable under sections 14 and 15 while expenses are

deductible under sections 16 and 17. There is no requirement that

an expense is deductible only on the condition that the income

in respective o such payment received at the other end o the

transaction is taxable in Hong Kong. In other words, generally there

is no matching o taxability and deductibility under prots tax.

However, with the introduction o sections 16(2)(c) and (2A),

the concepts o direct matching and indirect matching are ound in

the deduction o interest expenses under prots tax.

Borrowing Money Not From a Financial Institution

Section 16(2)(c) provides that, i a business borrows money

rom a company which is not a nancial institution, the interest

expense is deductible only when the interest income received by

the lender is taxable in Hong Kong. This carries the concept o

direct matching. In other words, the chargeability o tax on interest

income aects the deduction o interest expense on the loan

borrowed.

The ollowing three situations may arise:

a. Borrowingromanindividual

I the money is borrowed rom an individual who is usually

not chargeable with prots tax, the interest expense paid to an

individual is not deductible under prots tax as provided in section

16(2)(c).

Where loan is initiated Where unds are raised Chargeability to tax

In Hong Kong In Hong Kong 100% taxable

In Hong Kong Outside Hong Kong 50% taxable

Outside Hong Kong In Hong Kong 50% taxableOutside Hong Kong Outside Hong Kong 100% exemption




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b. Borrowingromanoverseascompany

I the money is borrowed rom an overseas company which

does not carry on a business in Hong Kong, the overseas company

will be exempt rom Hong Kong prots tax. Thus, the interest

income is not taxable Hong Kong. As a result, the interest expense

paid to an overseas company is not deductible under prots tax.

c. BorrowingromaHongKongcompany

I the money is borrowed rom a company which carries on

a business in Hong Kong, the interest income received by that

company is taxable Hong Kong. As a result, the interest expense is

deductible under prots tax.

The situations provided in section 16(2)(c) borrowing may be

summarised in the ollowing table:

As a side issue, i the borrowing is made rom a nancial

institution, no matter a oreign nancial institution or a Hong Kong

nancial institution, there is no such restriction that the interest

income received by the nancial institution must be taxable in Hong

Kong beore the interest paid by the business is deductible. Section

16(2)(c) does not apply to interest paid to a nancial institution.

Borrowing Secured by a Deposit or another Loan

It is provided in section 16(2A) that the chargeability o tax

on interest income on a deposit or another loan used or security

purposes aects the deduction o interest expense on the loanborrowed. This is reerred as “indirect matching”. I a loan satises

one o the conditions o sections 16(2)(c), (d) or (e), the deduction

o interest has to satisy the conditions provided by section 16(2A)

too.

Section 16(2A) provides that in order or an interest expense to

be deductible, one o the ollowing conditions have to be satised:

a. the loan is not secured by a deposit or another loan;

b. i the loan is secured by a deposit or another loan, the interest

income derived rom such deposit or loan used as security

must be taxable in Hong Kong;

c. i the loan is secured by a deposit or another loan, and the

interest income derived rom such deposit or loan used as

security is not taxable in Hong Kong, the amount o interest

expenses deductible under prots tax may be reduced in a

manner appropriate to the situation concerned (as determined

by the CIR); or

d. i the loan is secured by a deposit or another loan provided by a

person not associated with the borrower, the interest expense

is deductible even though the interest income is not taxable in

Hong Kong at the hand o the recipient.

The situations provided in section 16(2A) borrowing may be

summarised in the ollowing table:

To make the picture complete, students have to note that the

CIR reers this as the “Secured Loan Test”. I the security is not a

deposit nor another loan, the interest expense is deductible under

section 16(2A).

ConclusionInterest expense is incurred or nancing the operation o

a business and it is very oten one o the largest expenses o a

company. I a businessman does not pay attention to the deduction

o expenses when arranging its borrowing activities, he or she may

not get the deduction o interest in the computation o prots tax.

This will lead to an increase in the unnecessary prots tax expense

As interest income and interest expense are two popular areas in

the examination, students have to exert more eort on those two

topics.

Borrowed rom Interest income Interest expense

An individual Not taxable Not deductible

An overseas company Not taxable Not deductible

A Hong Kong company Taxable Deductible

Deposit provided by Deposit interest income Loan interest expense

An individual (associated) Not taxable Not deductible

An overseas co.(associated)

Not taxable Not deductible

A Hong Kong company Taxable Deductible

An individual(not associated)

Not taxable Deductible

An overseas co.(not associated)

Not taxable Deductible


Taxation o Interest, Deduction o Interest and their

Relationship under Prots Tax

(relevant to Papers 2.3 HKG & 3.2 HKG / F6 & P6)




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Corporate governance has been a avourite topic in recent

years especially ater the Enron’s scandal was exposed. Law

makers and regulators have been attempting to introduce new

rules and regulations to restore investors’ condence and public

trust on public listed companies. Following the Sarbanes-Oxley

Act o the United States enacted in 2002, new stricter corporate

governance rules and regulations are also introduced in other

countries as well:

Why Corporate Governance?

Corporate governance was dened as “a system by which

a company is directed and controlled” in the Cadbury Report,

1992. The report did not clariy the meaning o system, directed

and controlled. Instead, it provided detailed descriptions o the

structure and responsibilities o the Board, recommend Code o

Best Practices, etc.

There are a number o reasons to support why a corporate

governance system is needed or a company. Among others, the

major reasons include:

1. Protecting stakeholders’ interests;

2. Reinorcing shareholders’ trust and condence; and

3. Creating value or stakeholders.

Protectingstakeholders’interests

A company has many interactions with various parties in a

typical business environment regarding nancial and operational

matters. These parties may include investors, creditors, bankers,

regulators, customers, employees, etc. Each o these parties has

his own interest and agenda with the company. For examples,

investors have injected capital into a company and thereore

expecting a return which hopeully is above the market average;

bankers are lending money to the company on the ground that

the company is a going concern and can ulll its loan repayment

commitment; employees are providing their eort in return or a

monthly pay check and a career opportunity in the company.

However, as these parties are involved in the daily operation o

the company, they have very limited knowledge about the company

s background and operations. They do not know how well the

company is operating and whether their aspirations associated

with the company can really come true. They have limited access

to the ull inormation o the company they are associated with let

alone the knowledge o the adequacy o eective internal control

system in place. Even though they have the right to request or

inormation but more oten the inormation they are provided with

may be ltered or inadequate. Besides, they might not be able to

stop the company rom taking high-risk investments or projects

which may have impact on the company’s uture and in turn their

interests.

Obviously, ater the Enron’s case, everyone would agree that

an eective Corporate Governance system should be in place

to saeguard the assets o a company and hence the interests

o dierent stakeholders. This can be achieved, among others,

by enhancing the transparency and disclosure requirements o

signicant nancial and operating inormation. Stakeholders will be

able to make decision on a better inormed basis and assess the

company more meaningully.

Why Corporate Governance aMatter?(relevant to Papers 3.5 & 3.7 / P1)Clement Chan and Ricky ChengHorwath Hong Kong CPA Limited

2006 June The combined code on corporate governance issued

by Financial Reporting Council (rst published in 2003

July) in the United Kingdom

2004 November Code o corporate governance practices issued by

the Hong Kong Stock Exchange

2004 April Principles o corporate governance or listed

companies issued by the Tokyo Stock Exchange

2003 November Corporate governance rules approved by the New

York Stock Exchange2003 March Principles o good corporate governance and best

practice recommendations issued by ASX Corporate

Governance Council



Reinorcingshareholders’trustandconfdence

There are normally 2 classes o parties who can exercise

their rights to control the operations o a company, they are

shareholders and company’s management (i.e. the Board o

Directors and management team). In a small or private company,

owner-manager situation is very common where the owner and

management are reerring to the same batch o persons. In

a large or public listed company, these 2 parties are usually

segregated and shareholders tend to have l imited rights to control

the operations o a company except when there are signicant

events concerning the company such as merger or acquisition,

und-raising, etc.

In the latter situation, there is a segregation o ownership rom

control. That is, the delegation o authority and responsibilities

by shareholders to the company’s management or leading and

managing the company. Besides, shareholders place trust on themanagement and believe that the company will be managed to

achieve the desired goals and objectives. This is oten reerred

to the principal-agency relationship. Shareholders are principal

and management is the agent. Management is accountable to the

shareholders and acting in good aith and in their interests.

However, in the day-to-day operation, shareholders hardly

interere with management in their daily management o the

company. In the absence o an eective monitoring system, the

possibility o management inappropriately using their authority

to advance their personal benets will increase. This may bedriven by the various reasons such as management’s sel-interest,

nancial rewards, meeting business and operational targets, etc.

Thereore, a gap exists between the shareholders and management

regarding their interests.

There are a number o ways to narrow this gap. One o the

ways is to align their interests by introducing a perormance-related

remuneration package. This can link the company’s perormance

such as turnover, prot or other indicators with the management’

s remuneration and making sure that they are running in the same

direction.

Another way is to strengthen the corporate governance

practices, apart rom increasing disclosure, by (i) clearly dening

the accountability and responsibilities o management; and (ii)

establishing an eective Board o Directors. The latter one is more

important.

An eective Board can be measured by at least 2 things, one

is its composition and the other is its perormance. According

to the listing rules and Code o Corporate Governance Practices

issued by Hong Kong Stock Exchange, a Board o Directors must

include at least 3 independent non-executive directors (INEDs). As

a best practice, 1/3 o the Board should be made up o INEDs.

Besides, a Board should perorm eectively by scrutinizing the

activities o the company, questioning high-risk investments or

projects, monitoring management’s integrity, monitoring the results

o authority delegation, reviewing regular operational and nancial

reports.

Besides, it is very common or a Board o Directors to

establish dierent board committees to discharge their duties

and overseeing responsibilities. These committees include

remuneration committee, audit committee and nomination

committee. Appointment o committee members should alsoensure that they have the relevant experience, knowledge and skill

sets. For example, it is a requirement that there should be at least

one nancial expert in the audit committee.

With the above measures, shareholders can place more trust

and condence in the management with the increased supervision

and participation o an eective Board o Directors and interests

among the parties are being aligned.


Why Corporate Governance a Matter?

(relevant to Papers 3.5 & 3.7 / Paper P1)

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CreatingValueorStakeholders

An ideal and eective corporate governance system o a

company should also include a robust enterprise risk management

(ERM) process. Through the implementation o a systematic

process throughout a company, ERM can provide a company

with reasonable assurance to achieve its goals and objectives.More importantly, it can ensure that the company is operating

within the enterprise’s risk appetite. The ERM should include

internal environment, objectives setting, events identication, risk

assessment, risk response, control activities, inormation and

communication and monitoring.

ERM can create value or stakeholders by linking strategic

objectives with relevant risk actors, identiying events such as risk

and opportunities, preparing risk responses and viewing enterprise

risk actors as a portolio. The importance is to ensure that these

risk management elements are built into the operating businessprocesses and not just being considered on a standing alone basis.

In the context o ERM, the role and responsibilities o internal

audit unction will usually be touched on. Traditionally, internal audit

unction is viewed as a watchdog and being charged to ensure

the eectiveness o the check and balance mechanism within an

organization. The personnel to take up this role may also need to

involve in operation such as nancial reporting process. However,

with the increasing importance o corporate governance and risk

management, expectations on internal audit unction have been

raised to include the ollowing:

• Becoming a “partner” to operational departments in assisting

them to achieve their process objectives instead o detecting

wrongdoings;

• Independently reviewing business processes on a risk-basedapproach to identiy weaknesses or improvement opportunities

rather than looking or non-compliance;

• Assisting the management to align business operations with

corporate or entity-level objectives; and

• Assisting in reviewing and improving the risk management

process to ensure its eectiveness.

Finally, corporate governance aects every spectrum o an

enterprise rom the top management to operations, and not only

disclosure or paper work. The successul implementation o

corporate governance requires sel-discipline, a strong tone-at-the-top and the management with integrity to drive the process. In

return, value can be created or stakeholders.

Reerences:1. Code o corporate governance practices, The Hong Kong Stock

Exchange2. Enterprise risk management ramework, COSO 3. Audit Quality – Agency theory and the role o audit, The Institute o

Chartered Accountants

4. Report o the committee on the fnancial aspect o corporategovernance or “Cadbury Report”

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